Debt the dark horse in bubble debate

Charles Gave, of GaveKel Research in Hong Kong, wrote in a note last week that roughly a quarter of the world’s financial assets are in equities and three-quarters are in debt.

Out of an estimated $209 trillion of total global financial assets (excluding real estate), $52 trillion sits in equity, $45 trillion is in government debt, $65 trillion in loans (possibly a good chunk of which finances real estate) and $46 trillion in corporate debt.

Considering the relative weights of equities and debt, it is somewhat surprising that most of what we read and hear about the global financial markets is about equities, not debt.

Debt is also much, much more powerful than equities. Look at what started the global financial crisis; wrongly rated collateralised debt obligations held and/or issued by over-leveraged investment banks.

Then there was the euro zone crisis, triggered when the threatened default by Greece exposed the parlous debt condition of Spain and Portugal and the banks that had bought their sovereign bonds.

The solution to the crises spawned by the reckless accumulation of debt has been the creation of more debt mainly in the form of quantitative easing by central banks.

Ominously, we are seeing signs of overheating in credit (the obverse of debt) markets. Junk bond issuance set a record high in 2012. Over the past 15 months, the yield offering on US B-rated or junk bonds has fallen from 9.5 per cent to around 6 per cent. (When bond yields fall their price increases.)

All credit markets – not just junk bonds – have been aggressively bought as investors reached for yield.

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Not surprisingly, given the role of debt in the global financial crisis, some analysts are asking: how bubbly is the debt market?

It’s difficult to answer that question because, as US Federal Reserve governor Jeremy C. Stein pointed out in a speech* earlier this month, credit overheating that poses a potential threat to financial stability is “one of the most difficult jobs that central banks face".

He said: “As compared with inflation or unemployment, measurement is much harder, so even recognising the extent of the problem in real time is a major challenge. Moreover, the supervisory and regulatory tools that we have, while helpful, are far from perfect."

The first reason for this is that the composition of credit markets is significantly different from that of equity markets.

The equity market can be seen as “primitive", where changes in pricing over time reflect fluctuations in the preferences and beliefs of end investors, such as households, where these beliefs may or may not be entirely rational. In credit markets, decisions are almost always delegated to agents inside banks, mutual funds, insurance companies, pension funds, hedge funds and so forth. These agents face incentives and these, as Stein points out, are in turn shaped by the rules of the game, including regulations, standards and compensation.

Stein offers three factors that he sees as potential contributors to over-heating, beginning with financial innovation, which “can create new ways for agents to write puts that are not captured by existing rules". ( The hedge fund industry is a major user of put options.)

The second factor he nominates is new regulation that spurs innovation in product design and distribution.

The third factor is a change in the economic environment that alters the risk-taking incentives. For example, a prolonged period of low interest rates, like we are experiencing today, can create incentives for agents to take on greater duration of credit risks, or to employ additional financial leverage, in an effort to “reach for yield".

Stein believes we are now seeing a “fairly significant pattern of reaching-for-yield behaviour emerging in corporate credit". While this does not bode well for junk bond and leveraged-loan investors, it does not follow that this risk-taking has ominous systemic implications.

He says “one lesson from the crisis is that it is not just bad credit decisions that create systemic problems, but bad credit decisions combined with excessive maturity transformation".

The question that always needs to be asked is: “What fraction of any loan is ultimately financed by short-term demandable claims held by investors who are likely to pull back quickly when things start to go bad?"